The Bonus Explainer

How did the AIG executive “bonuses” become a legal obligation?

President Obama expressed outrage on Monday at the use of federal bailout money to pay $165 million in bonuses to AIG employees and ordered the Treasury Secretary to use all legal means to prevent the payments. Yet some administration officials have cautioned that the company has a legal obligation to make the payments. Why would AIG have to pay out its “bonuses”?

Because that’s what it agreed to do. Many top executives have employment contracts that specify a formula for computing their annual bonuses. These formulas usually incorporate some measure of overall company performance (stock price, free cash flow, or net income, for example) or the performance of the unit for which the executive is responsible. At some firms, the bonus formulas are freely determined by the board of directors and left out of any employment contracts—but the board may limit its own right to change the formula. It might, say, promise not to change the formula after a specific date. If the company then failed to pay under the original formula, a disgruntled executive could sue the firm for failing to follow its own rules. Under pressure from shareholders, many corporations are becoming more proactive about reserving the right to change their bonus structures. Some boards even reserve the right to recover bonuses already paid if there is evidence of bad behavior by the recipients.

Employee bonuses have their roots in Christmas. Through the end of the 19th century, many employers offered a year-end bonus in the form of a gift. (Montgomery Ward once distributed 7,500 turkey dinners.) In the early 20th century, most large employers converted the bonuses to cash, often a percentage of an employee’s annual salary. The practice had become widespread by 1952, when the National Labor Relations Board ruled that a Christmas bonus qualified as wages, rather than a gift, as long as it was paid at the same time and in a predictable amount every year. Today, only about 40 percent of employers hand out across-the-board holiday bonuses, and many of those have switched back to noncash gifts. (Some jurisdictions are stubbornly hanging onto the tradition. Puerto Rico enacted a mandatory Christmas bonus law in 1969 and strengthened it in 2005.)

Performance-based bonuses have increasingly replaced Christmas bonuses. While the Wall Street bonus pool sank by 44 percent last year, it was still the sixth-highest ever. In addition to bonuses for top executives, most companies grant “bonus pools” to managers for distribution to their subordinates. Some companies pay lower-tier employee bonuses on a purely discretionary basis, meaning that the company can decide not to pay a bonus with no consequences (aside from the risk of losing employees).

Contractually Obligated Bonus Explainer: What did Treasury Secretary Timothy Geithner mean when he conceded last week that failing to pay the bonuses could result in punitive damages? It’s hard to say. Breaches of contract rarely, if ever, give rise to punitive damages. Some state labor laws penalize any company that fails to pay its employees by requiring that late wages be doubled or tripled in size. Bonuses have so far been construed as wages under these laws only if they are based on the performance of the employee (as opposed to the performance of the company as a whole).